Short selling is a form of trade whereby a seller borrows an asset from a lender, hoping that the price will fall from their original price, thereby enabling the seller to profit. For example, if you short a company’s stock when it is at $100 per share, it means that you expect it to fall, while the entity lending you expects it to rise.
If the price falls to $90, you will make a $10 profit because its sale price will be lower than the price at which you “borrowed” it. However, if the stock price rises to $110, you will lose $10 because the new price will be higher than the price at which you “borrowed” it.
Shorting is, therefore, based on selling at a higher price and buying back at a low price (excluding fees). Therefore, investors short assets when they believe that their value will decline in the coming days.
Below are the steps to navigate short-selling.
- An investor is convinced that an asset such as a currency pair is likely to lose its value in the future. Therefore, they want to “sell” the asset at the current price when it is still high and buy it back when the price depreciates.
- However, since the investor does not actually own the asset, they approach a company or any other investor who owns it. They pay the transaction fee and a margin fee if the pair’s value appreciates before the deal is closed.
- If the currency pair falls in value, the short seller will make a profit equivalent to the difference between the currency pair’s original price and its new price.
- If the price appreciates, the investor will purchase them at a higher price, and the loss accrued will be equivalent to the difference between the current price and the purchase price.
Ethical dilemma in shorting
Short selling is among the most controversial forms of trading because of the push-and-pull between short-sellers and company executives. There is always a significantly high level of suspicion as to whether or not some of them use underhand tactics to have their way.
For example, it is a commonly held belief that company executives will sell hope and express optimism even when the company is underperforming. On the other hand, short-sellers are often viewed with suspicion and are at times accused of starting misleading rumors to tilt the scales in their favor.
Below is an outline of the ethical issues raised against shorting in various segments of securities markets.
By its very design, short selling is a way of hoping that a company performs poorly so that the short seller benefits. As long as a company’s stock keeps rising and its fundamentals are healthy, short sellers cannot be profitable. Therefore, short-sellers are always viewed with suspicion by companies. At times, frequent heavy attacks between companies and short-sellers turn ugly. It is not uncommon for them to go to the extent of legal action in courtrooms.
Like in stock markets, short-sellers also stir controversy in currency markets. The stakes are higher in currency markets because, unlike stocks that are attached to companies, currencies are attached to national economies. Therefore the collapse of a currency can adversely affect entire national economies.
One of the most memorable currency-dumps was the shorting of the GBP in 1992 by influential billionaire George Soros. This had a far-reaching impact on the Bank of England and planned monetary union in the European Union. Therefore, shorting a currency is often seen as a form of ill will against a country.
Strategies for short selling
Short sellers often open long positions as a way of hedging against risks. To use shorting as part of a hedging strategy, you can use the following approaches:
- Some managers use risk arbitrage as a way of hedging their portfolios. A common practice to do this whereby the manager acquires the stock of a company being acquired and shorts the company making the acquisition.
- The second way to hedge a short position is to use two stocks, with one in a long position and the other in a short position. Pairing trades are usually employed on two stocks in the same industry but very competitive amongst themselves. This is mainly aimed at neutralizing risks in case one of the two positions fails. For example, you can short Toyota and long GM, short Microsoft and long Apple, etc.
Hedging differs from diversification in that diversification is about taking up multiple investment positions in the hope that in case some of the investments fail, then the rest will succeed and cover the losses. However, some investors prefer going all-in by shorting all their positions with the hope of increasing their profit margins.
The downside to this is that the risk taken is very high, and they may lose a large number of their investments if the markets go against them. With this type of shorting, you can bet against specific stocks or short an index like the Dow Jones Industrial.
Short selling is a high risk/high reward trading strategy that requires skills to get the correct interpretation of the market through technical and fundamental analysis. In addition, you must be willing to play by the rules of the shorting world, which requires a deep-rooted understanding of the market.